Haggling on the Hill

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There was lofty talk of bipartisanship in Washington, DC, this week as a bill to rescue struggling homeowners cleared a key Senate committee, the biggest hurdle it is likely to face. But the noise in the background was the unmistakable sound of horses being traded.

Democrats got their expansion of the Federal Housing Administration (FHA), the government agency that supports low-cost housing. It will guarantee up to $300m of refinancing of “underwater” mortgages as long as lenders agree to cut the principal owed to below the home’s current value (a big if; the scheme is voluntary).

But Republican sceptics extracted their pound of flesh. The cost will be limited to $500m, and covered not by the taxpayer but by America’s housing-finance giants, Fannie Mae and Freddie Mac (known as Government Sponsored Entities, or GSEs). More importantly, Fannie and Freddie will face much stricter regulation. As Rajiv Setia of Barclays Capital puts it, to secure the mortgage-rescue plan “the Democrats essentially gave in on the GSEs”.

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Reform of Fannie and Freddie, today regulated by the feisty but legally toothless Office of Federal Housing Enterprise Oversight (OFHEO), has long been a White House goal—especially since they were caught misstating earnings a few years ago. Some worry that their vastness poses a systemic risk: at $5.3 trillion, their portfolios exceed the total stock of American government debt in private hands. Concern has only risen as private mortgage lenders have retreated; the GSEs’ share of monthly issuance of mortgage securities has doubled, to 84%, since 2006.

Curbs imposed after the accounting debacle limited the damage this time. Fannie and Freddie have nevertheless lost a combined $11.1 billion in the past three quarters. In March confidence in them all but evaporated, sending the spread over Treasuries on GSE-backed securities above the levels where even junk bonds were trading before the crisis. It has since fallen back, but remains high.

A new regulator would have powers akin to those of a bank supervisor. It could insist on asset disposals and, crucially, enforce standards for the firms’ portfolios, such as their rate of growth. It could also coax Fannie and Freddie into operating counter-cyclically by building capital in good times and lowering requirements in falling markets. Pro-cyclical regulation exacerbated the credit crunch.

The regulator would have control over the GSEs’ capital levels, which are now determined by Congress. The minimum requirement is sure to rise over time, even if Fannie and Freddie are cut some slack until markets stabilise. James Lockhart, OFHEO’s director and the putative first boss of the new agency, recently called them a “point of vulnerability” because of their lofty leverage. Fannie would have to double its core capital to be considered a well cushioned commercial bank.

The GSEs argue that this is a false comparison, since the bulk of their portfolios is made up of guarantees, not loans. But Barclays Capital’s Mr Setia sees a tougher regulatory regime as a “huge long-term positive” for markets, as it should restore confidence in their devalued debt. It may also assuage fears of another blow-up.

It is not all bad for the housing giants. They should like the FHA provisions, since the agency can now refinance loans that they might otherwise have to write down. And their pricing power has grown as Wall Street’s mortgage desks have imploded, so they should be able to afford the cost.

Still, expect them to lobby hard against regulation when the bill moves to the Senate floor. There are numerous differences between the House and Senate versions to exploit, points out Bert Ely, a GSE-watcher. He sees a reasonable chance of the legislation being watered down. Fannie and Freddie are not yet in the corral.